FIN4426_Chap_1_s - Learning Outcomes: After reading this...

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1 INVESTMENT ANALYSIS FIN 4426 CHAPTER 1 THE INVESTMENT SETTING Learning Outcomes: After reading this chapter, students should be able to answer the following questions: Why do individuals invest? What is an investment? How do investors measure the rate of return on an investment? How do investors measure the risk related to alternative investments? 1-2 Learning Outcomes: What factors contribute to the rates of return that investors require on alternative investments? What macroeconomic and microeconomic factors contribute to changes in the required rates of return for investments? 1-3 What Is An Investment? Definition: A current commitment of money for a period of time in order to derive future payments that will compensate for: The time the funds are committed The expected rate of inflation Uncertainty of future flow of funds Reason for Investing: By investing (saving money now instead of spending it), individuals can tradeoff present consumption for a larger future consumption. 1-4 What Is An Investment? Pure Rate of Interest It is the exchange rate between future consumption (future dollars) and present consumption (current dollars). Market forces determine this rate. Example: If you can exchange $100 today for $104 next year, this rate is 4% (104/100)-1. Pure Time Value of Money The fact that people are willing to pay more for the money borrowed and lenders desire to receive a surplus on their savings (money invested) gives rise to the value of time referred to as the pure time value of money. 1-5 What Is An Investment? Other Factors Affecting Investment Value Inflation : If the future payment will be diminished in value because of inflation, then the investor will demand an interest rate higher than the pure time value of money to also cover the expected inflation expense. Uncertainty : If the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate to provide a risk premium to cover the investment risk Pure Time Value of Money. *Risk premium: the additional return added to the nominal, risk-free interest rate 1-6
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2 What Is An Investment? The Notion of Required Rate of Return The minimum rate of return an investor require on an investment, including the pure rate of interest and all other risk premiums to compensate the investor for taking the investment risk. Investors may expect to receive a rate of return different from the required rate of return, which is called expected rate of return . 1-7 Historical Rates of Return Return over a Holding Period Holding Period Return (HPR) -answer in decimal point -can not be a negative value Holding Period Yield (HPY) HPY=HPR-1 1-8 Investment of Value Beginning Investment of Value Ending HPR = Annual HPR and HPY Annual HPR = HPR 1/n Annual HPY = Annual HPR -1 = HPR 1/n – 1 where n=number of years of the investment
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This note was uploaded on 10/04/2011 for the course FINANCE FINANCE taught by Professor Don'tknow during the Spring '09 term at American Internation College.

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FIN4426_Chap_1_s - Learning Outcomes: After reading this...

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